Last year’s decision in Mayo Found. for Med. Educ. and Research v. United States, 131 S. Ct. 704 (2011), was generally hailed as a big victory for the government in holding that deference to Treasury Regulations would henceforth be governed by the generally applicable Chevron standards, not by the less deferential National Muffler Dealer standards that had previously applied in tax cases. See our report here. In Dominion Resources v. United States, CAFC No. 2011-5087 (May 31, 2011), however, the Federal Circuit reminded Treasury that being treated like every other agency is not always a bed of roses – for example, you can have your regulations invalidated for the agency’s failure to provide an adequate supporting rationale when the regulations were promulgated. Together with the Supreme Court’s recent decision in Home Concrete, the courts have flashed a yellow caution light in the face of those who thought that the practical effect of Mayo would be to give Treasury almost unfettered authority to legislate by regulation.

Dominion Resources involved a complicated capitalization issue important to the utility industry. Specifically, it addressed the validity of a regulation issued under Code section 263A. In general, the Code requires that costs of improving property must be capitalized, not deducted. Certain indirect costs, like taxes and interest, must be capitalized to the extent those costs are “allocable” to improving property. Under section 263A(f)(2), allocable interest includes not only obvious expenditures like interest on a loan taken out to fund the improvements, but also interest on other indebtedness “to the extent that the taxpayer’s interest costs could have been reduced if production expenditures . . . had not been incurred.” This section implements a notion of “avoided cost” by including “interest costs incurred by reason of borrowings that could have been repaid with funds expended for construction.” S. Rep. No. 99-313, at 144.

The regulation at issue in Dominion Resources defines “production expenditures” for purposes of this avoided-cost calculation, and it includes in that amount the adjusted basis of property that must be temporarily withdrawn from service to complete the improvements. Treas. Reg. § 1.263A-11(e)(2)(ii)(B). In this case, Dominion replaced coal burners in two of its plants and had to shut them down for a few months to do the work. It challenged the validity of the regulation, which had the effect of requiring it to capitalize, rather than deduct, a larger portion of its interest on unrelated indebtedness because of the inclusion of the adjusted basis of those properties as “production expenditures” for allocation purposes.

The Court of Federal Claims ruled for the government, in an opinion that appeared to highlight the difficulty of attacking regulations that are entitled to Chevron deference. The court expressed considerable skepticism about the logic of the regulation, stating that “[i]t is stretching the statute quite far to say that the associated-property rule ‘is a “reasonable interpretation” of the enacted text’” (quoting Mayo). The government’s suggested rationales for including adjusted basis, in the court’s view, were “not very satisfying.” Indeed, one suggested rationale (the idea that the property could be sold at a value equal to its basis in order to pay down the debt) was “removed from reality” because the property was intended to remain in service. The court also suggested that the regulation was bad policy because it created a tax disincentive to improvements. In the end, however, the trial court concluded that it is a “very close case” and that it “cannot say that the Treasury overstepped the latitude granted by the statute to adopt regulations” – in other words, the Chevron Step 2 bar of being a “reasonable” interpretation of the statute is sufficiently low that the regulation should survive despite the court’s criticism.

The Court of Federal Claims also responded to the taxpayer’s argument that the regulations failed to comply with the Administrative Procedure Act. Treasury regulations traditionally have not often been challenged on APA grounds, but Mayo’s holding that such regulations should be given the same deference as regulations issued by other agencies has brought to the fore the idea that other general administrative law principles, including APA rules, should apply equally to Treasury regulations. (Judge Holmes of the Tax Court has been particularly outspoken about the applicability of the APA and general administrative law principles to tax cases – both on the bench (see his concurring opinion in the Intermountain case, 134 T.C. 211, 222-23 (2010), which was recently upheld by the Supreme Court on other grounds in Home Concrete) and off the bench (see Shamik Trivedi, Mayo Increases Taxpayer Chances of Success, Judge Says, Tax Notes, June 27, 2011, p. 1319)).

In Dominion Resources, the taxpayer argued that the regulation ran afoul of the APA’s “arbitrary [and] capricious” standard on the grounds addressed in Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983). The Supreme Court there stated that an agency must “articulate a satisfactory explanation for its action,” that is, “cogently explain why it has exercised its discretion in a given manner.” Id. at 43. The trial court in Dominion Resources found that it was “a stretch to conclude” that Treasury had provided this cogent explanation, but observed that Treasury’s “lack of exactitude and the ensuing confusion do not signify that Treasury acted to establish the final rule in an arbitrary and capricious manner.” Instead, the court seized on the Supreme Court’s statement in State Farm that “a decision of less than ideal clarity” can be upheld “if the agency’s path may reasonably be discerned.” Id. The court held that Treasury’s “‘path’ . . . can be ‘discerned,’ albeit somewhat murkily,” and on that basis it rejected the APA challenge.

The Federal Circuit was less forgiving, and it invalidated the regulation. The majority (Judges Rader and Reyna) agreed with both of the taxpayer’s primary arguments. With respect to the Chevron analysis, the majority echoed the trial court’s criticisms of the regulation and concluded that they required a different outcome. The majority stated that the regulation passed Chevron Step 1, “but only because the statute is opaque” and therefore “ambiguous.” But the regulation failed the Step 2 reasonableness test because, in the majority’s view, it “directly contradicts the avoided-cost rule that Congress intended the statute to implement.” Moreover, the court stated, the regulation “leads to absurd results” because it “can require capitalizing vastly different amounts of interest for the same improvements” – if the different properties had different adjusted bases. The court noted that the Court of Federal Claims had correctly described the government’s argument that the property owner could have sold the unit in order to pay the debt as “removed from reality,” but found that the trial court erred in excusing that “fiction [as] a ‘policy choice’ by the agency and thus permissible.” Because the government’s proffered rationale was unreasonable, “the regulation is not a reasonable interpretation of the statute.”

The Federal Circuit also ruled that the trial court had erred in rejecting the taxpayers’ APA argument. The court stated that the notice of rulemaking “provides no explanation for the way that use of an adjusted basis implements the avoided-cost rule” and hence failed to satisfy the State Farm requirement that “the regulation must articulate a satisfactory or cogent explanation.”

Judge Clevenger concurred in the result, agreeing with the majority’s APA analysis but disagreeing with its Chevron analysis. In his view, the majority’s approach swept too broadly because it “creates a binding rule . . . that the government can never re-promulgate its associated-property rule for property temporarily withdrawn from service, no matter how well-formed its reasoning.” Judge Clevenger would have preferred a narrower resolution that deemed the regulation “procedurally unlawful” for the government’s failure to “articulat[e] any rational explanation for many details of the regulation . . . up to the current date.” That approach “would give the government another chance to explain and justify its view that the adjusted basis of property temporarily withdrawn from service can be taken into account in determining production expenses.”

Judge Clevenger then went on to provide a possible rationale for the regulation, describing it as an attempt to approximate “opportunity costs” — that is, “the lost value associated with the withdrawal of property from service” — in a way that does not present overwhelming administrative difficulties. He did not dispute the majority’s criticism of the notion that the taxpayer could have sold the property to service the debt as “fiction.” But he asserted that “the avoided cost rule is in its entire concept a fiction,” and therefore this was not enough of a reason to conclude that the regulation fails Chevron Step 2.

The Dominion Resources opinion is significant on two levels. First, the specific holding concerning whether adjusted basis plays a role in determining how much interest must be capitalized to improvements resolves a recurring issue that is particularly important in the utility industry and can involve significant amounts of tax. Second, the APA holding that Judge Clevenger characterized as “narrower” may in fact have an even broader impact. It is not unusual for Treasury regulations to be accompanied by a less-than-illuminating explanation of how the regulation implements the statutory purpose. In the wake of Dominion Resources, taxpayers can be expected to raise APA challenges to such regulations, and some of those may succeed. As Judge Clevenger stated, the impact of invalidation on State Farm grounds presumably can be limited by repromulgating the regulation with a satisfactory explanation. But unless retroactive application of the repromulgated regulation can be justified, Treasury would stand to lose the benefit of the regulation for a significant period. Thus, one ancillary effect of increased scrutiny of Treasury regulations on State Farm grounds could be increased litigation over Treasury’s power to issue retroactive regulations – an issue that the Supreme Court did not touch in Home Concrete (see our report here).

Given the significance of the decision, it would not be surprising for the government to seek further review. A petition for rehearing en banc would be due on July 16.

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Authors

Steve Dixon is a Member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a Member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.